The Fed should target inflation (as it is wrongly conceived by the public)

It’s a pretty well-established fact that the public thinks inflation is higher than the official statistics show.  I believe that’s because the public thinks of the “cost of living” in a slightly different way from how economists think of the term.  If the average phone bill was $30/month in 1970 and its $60/month today, then people think the cost of phone service has doubled, even if the price of a long distance call has fallen by 99%.  If popular models of color TVs now cost the same $400 as in 1960, then the price is unchanged in the public’s mind, even if the BLS says TV prices are down by 90%.  Only for items like gasoline do the public and BLS agree.

To the public, the “cost of living” is the amount of income you need to have a normal lifestyle.  What’s a normal lifestyle?  Roughly the lifestyle of your neighbors. And since both income and consumption tends to rise a bit faster than the CPI, the public’s estimates of the rate of inflation are slightly higher than the BLS’s estimate.  (I’m cheating a bit here; I actually think the public is composed of a mixture of people who understand what the BLS is measuring, and those who don’t.)

Let’s say the public does think of the cost of living in terms of the amount of money needed for an average lifestyle.  In that case, what variable should the Fed stabilize?  Obviously growth in average incomes.  And if population growth is fairly steady at 1% per year, then one way of stabilizing average per capita income growth at 4% per year, would be to set a 5% NGDP target.

So the public actually favors NGDP targeting, they just don’t know it.

BTW, if my theory were correct then the Chinese people should believe that the cost of living in China is rising really, really fast, even though the inflation data shows a very slow rise in prices.  That’s because nominal incomes are rising very fast in China.

And they do!  It may be hard to believe, but the Chinese people were complaining bitterly about inflation back in 2010, when the Chinese CPI was rising by 2.7% and their nominal incomes were soaring at double digit rates.

It’s all about “keeping up with the Zhangs.”

PS.  In addition to the article I linked to, I’d like to cite my wife as a source.  She tells me that the Chinese people feel that prices in China have risen very rapidly in recent years.

PPS.  Some people claim that NGDP targeting is a bad idea because the public doesn’t understand NGDP, but they do understand inflation.  OK, the Fed should tell the public they plan to target the “real price level.”  To the public that phrase will sound like the “actual price level,” not the phony numbers that the BLS puts out, which (according to Peter Schiff) make inflation look lower than it really is.  The Fed’s reputation will rise.  The public will think; “Aha, I knew all along inflation was more than 2%.”  The “real price level” is also a dog whistle to economists that the variable being targeting is real output times the price level.


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39 Responses to “The Fed should target inflation (as it is wrongly conceived by the public)”

  1. Gravatar of Morgan Warstler Morgan Warstler
    31. July 2013 at 12:03

    This is WHY we need a new economic measure of growth.

    It should take the original long tims cost of things like:

    60″ HDTV originally $50K

    Cost of calling anywhere on globe $10K+ yr.

    And then say to Americans:

    Technologists have delivered all of you $49K whenever you buy a $1K 60″ TV.

    Skype = $10K a yr in free long distance.

    ——

    The fact is that while govt. and Fed economists have done nothing of value for 20 years…

    During that time, the technologists have delivered ALL of the income gains, but SURE ENOUGH, the self-interest knobs at the Govt. and Fed, don’t want to preach REALITY since it reduces their value to nil.

    EVERYONE in America has a better life today because of entrepreneurs and technologists.

    Only technologists deserve any praise and any control of our future.

    http://siliconangle.com/blog/2010/05/27/technologists-a-call-for-a-metapolitical-party/

  2. Gravatar of Brian Donohue Brian Donohue
    31. July 2013 at 12:17

    This is very good. Thank you.

  3. Gravatar of Staffan Staffan
    31. July 2013 at 12:45

    Great post.

  4. Gravatar of J J
    31. July 2013 at 13:04

    Professor Sumner,

    You said: “To the public, the “cost of living” is the amount of income you need to have a normal lifestyle. What’s a normal lifestyle? Roughly the lifestyle of your neighbors. And since both income and consumption tends to rise a bit faster than the CPI, the public’s estimates of the rate of inflation are slightly higher than the BLS’s estimate.”

    But, based on complaints about inflation in Europe, I believe that the public also confuses real wages with inflation. When the amount of real goods and services they can buy falls or remains stagnant, the public perceives the problem as one of prices rising too quickly rather than real wages stagnating. They assume that the price level is determined independently of nominal wages.

    If this is true, then higher NGDP growth, for a given rate of inflation, should lead to a decrease in the public’s inflation estimates. I appreciate that this runs counter to your evidence from China. Yet, your theory provides no explanation for increased public fears of inflation in Europe where inflation and nominal wage growth are both low.

  5. Gravatar of Bill Ellis Bill Ellis
    31. July 2013 at 13:04

    Smart.

  6. Gravatar of Bill Ellis Bill Ellis
    31. July 2013 at 13:05

    Off topic…Obama is bumming me out.
    http://www.huffingtonpost.com/2013/07/31/larry-summers-obama_n_3682908.html

  7. Gravatar of maynardGkeynes maynardGkeynes
    31. July 2013 at 13:34

    Prof Summers, suppose I said that the general public thinks in terms of nominal dollars, not “real” (constant purchasing power) dollars. That would seem to be the same as what you are saying about TV prices and telephone services. I do see how that supports what I think is your main contention, that “to the public, the ‘cost of living’ is the amount of income you need to have a normal lifestyle.” What I don’t quite see is why you would argue in favor of an economic policy (NGDP targeting) based on what is obviously a fundamental (but common) “money illusion.” Does that explain the title of your blog? Oh no….

  8. Gravatar of Questioning the Government’s GDP Numbers Questioning the Government’s GDP Numbers
    31. July 2013 at 13:36

    [...] Scott doesn’t just take the BLS’ word over the experience of average Americans; he also trusts the Chinese government’s numbers over the perceptions of the [...]

  9. Gravatar of maynardGkeynes maynardGkeynes
    31. July 2013 at 13:53

    Professor Sumner, a thousand apologies, I had just finished the appalling comments of Obama on Larry Summers, and that was on my mind.

  10. Gravatar of ssumner ssumner
    31. July 2013 at 14:26

    Maynard, This was a spoof. I do favor NGDP targeting, but certainly not because the public (falsely) links it to inflation.

  11. Gravatar of ssumner ssumner
    31. July 2013 at 14:27

    J, I’m not sure about the situation in Europe. I think it will take some time to figure out why they think inflation is high. What is the public perception of inflation in Europe, BTW?

  12. Gravatar of TravisV TravisV
    31. July 2013 at 14:37

    Prof. Sumner,

    On his blog, Marcus Nunes recently wrote:

    “QE is not a permanent solution because central bank balance sheets cannot increase indefinitely.”

    http://thefaintofheart.wordpress.com/2013/07/30/needed-a-move-from-qe-to-an-ngdp-level-target

    Do all market monetarists agree? Is there some scenario where aggressive balance sheet expansion would create a crisis other than higher inflation?

    Other than inflation, what would happen that would force the central bank to stop expanding the balance sheet?

  13. Gravatar of TravisV TravisV
    31. July 2013 at 15:01

    Bob Murphy replies to Prof. Sumner:

    http://consultingbyrpm.com/blog/2013/07/questioning-the-governments-gdp-numbers.html

  14. Gravatar of ssumner ssumner
    31. July 2013 at 15:17

    Travis, It depends why the balance sheet expands so sharply. But I doubt it would be a big problem, more likely it might reflect big problems in other areas of the economy.

    As far as Murphy, I just hope he was joking. The alternative is painful to contemplate.

  15. Gravatar of Doug M Doug M
    31. July 2013 at 16:15

    “To the public, the “cost of living” is the amount of income you need to have a normal lifestyle. What’s a normal lifestyle? Roughly the lifestyle of your neighbors.”

    “It’s all about “keeping up with the Zhangs.””

    If it all about keeping up with the Zhangs, then there is nothing for the fed to target. If the Fed makes everyone a dollar wealthier, then they have made the Zhangs a dollar wealthier do, and if you feel like you are not keeping up then you are still not keeping up.

    And what is keeping up. If the Morrison’s have an infra-red freezer-oven that converts an block to beef bourguinion in 8 seconds but you have a two-speed hedge cutter, are you keeping up, or do you look over the hedge and think to yourself “lucky bastards.”

    And, if you actually do conclusively catch-up to — or, gasp, get ahead of — your neighbors, what do you do? Move across town and live next to richer neighbors.

    But what is inflation in the “public’s mind.” Since there is no such thing as public opinion, there is no real answer, but I am going to suggest it is gas prices. And then, their concept of high gas prices has usually a fixed anchor point. If gas prices are above 4 dollars gas prices are high and we are experiencing inflation. There is no concept of how much the price has actually moved, or over what time period. It doesn’t matter that gas prices have been bouncing in this range for 3 years, or that we crossed $4 in 2006.

  16. Gravatar of Geoff Geoff
    31. July 2013 at 17:11

    “And if population growth is fairly steady at 1% per year, then one way of stabilizing average per capita income growth at 4% per year, would be to set a 5% NGDP target.”

    Why not set a 1000% NGDP target and we can all be millionaires?

    Cost of living changes over time is not well represented by nominal dollar expenditure changes over time.

    Cost of living should be measured in real terms, that is, real goods that are able to be purchased after so many hours worked.

    Focusing on dollars only is a seriously misleading approach.

    Here is a chart of real wages since the 1920s:

    http://i.imgur.com/cn2p1Rq.jpg

    Can anyone guess what major event took place in the early 1970s that might be responsible for this?

    The public doesn’t want NGDP targeting. They want sound money.

  17. Gravatar of Lorenzo from Oz Lorenzo from Oz
    31. July 2013 at 17:53

    So, the public does not believe we are “really” in a barter economy with money as a epiphenomena … Don’t tell the RBC folk that …

  18. Gravatar of Edward Edward
    31. July 2013 at 18:06

    “The public doesn’t want NGDP targeting. They want sound money.”

    What a loaded term. Money is a tool of exchange. Thats its primary function. all other functions are secondary to that. We shouldn’t treat money as a fetish The public wants money that serves their needs the best., and gold isn’t it. Mistaking Correlation with Causation with regards to the Nixon shock isn’t a sound argument

  19. Gravatar of Edward Edward
    31. July 2013 at 18:08

    And besides. The Bretton Woods regime wan’t a real gold standard according to faith based Austrian religious dogma

  20. Gravatar of Saturos Saturos
    31. July 2013 at 18:11

    So according to you, the public believes inflation is going down when their real incomes fall whilst the price level is flat? The public is happy when the Fed boosts RGDP even if prices are constant, not because they get more resources but because they are being compensated for the rising cost of things? I know the public is confused but I didn’t think it was that bad.

  21. Gravatar of Geoff Geoff
    31. July 2013 at 18:17

    Edward:

    “What a loaded term.”

    Thank you.

    “Money is a tool of exchange.”

    Money is a commodity.

    “Thats its primary function.”

    Agreed.

    “all other functions are secondary to that. We shouldn’t treat money as a fetish”

    Says the centralized money monopoly fetishist.

    “The public wants money that serves their needs the best., and gold isn’t it.”

    That’s your personal subjective value judgment that you are arrogating to be some sort of objective law that ignores my, and everyone else’s value judgments.

    If gold doesn’t “serve the public’s need”, then you should have no problems with a new law that legalizes gold as a money competing with the dollar, which means without gold owners being taxed in dollars if the dollar is inflated and the paper price of gold goes up.

    I am not demanding that gold be IMPOSED on you, the way you are demanding paper to be imposed on me. Unlike you, I am civilized and intend to settle differences of value judgments concerning one’s own person and property peacefully and intellectually.

    “Mistaking Correlation with Causation with regards to the Nixon shock isn’t a sound argument.”

    I didn’t make any statement that because there is correlation, there is causation.

    You are having your head in the sand.

    You haven’t even attempted to explain the graph. Why?

  22. Gravatar of Geoff Geoff
    31. July 2013 at 18:17

    Edward:

    “And besides. The Bretton Woods regime wan’t a real gold standard according to faith based Austrian religious dogma”

    Who said otherwise?

  23. Gravatar of Geoff Geoff
    31. July 2013 at 18:19

    And what faith based religious dogma are you talking about? That individuals act? Oh wow, how creationist. That humans can use self-reflective ratiocination to discern truths about the world? Geez louise, such theological nonsense.

    I bet you had no idea that it is precisely you who is spewing religious dogma, and your religious God is “society”, and individual humans are but cells, means, pawns to that all mighty being (which your ideas are to be used as a guide of course).

  24. Gravatar of Geoff Geoff
    31. July 2013 at 18:21

    Saturos:

    “So according to you, the public believes inflation is going down when their real incomes fall whilst the price level is flat? The public is happy when the Fed boosts RGDP even if prices are constant, not because they get more resources but because they are being compensated for the rising cost of things? I know the public is confused but I didn’t think it was that bad.”

    The public has to be stupid whenever there is an idea that needs to be implemented that is contrary to the public’s beliefs.

    When one agrees with the public on something, then the public opinion is sacred and should be honored.

    Hypocrites galore here.

  25. Gravatar of ssumner ssumner
    31. July 2013 at 18:31

    Doug, I think you missed the point. It was a spoof. I just meant the idea of the policy would sound good to the public. I certainly don’t believe it would cause them to magically think they are keeping up with their neighbors.

    Saturos, No, I didn’t explain myself well. I wasn’t focused on what makes the public happy, but rather on how they think about the term “cost of living.”

    But you are right, a supply shock can also lead to a perception of inflation, and that’s different from my example. I’m thinking more in the long term in this case.

  26. Gravatar of Keshav Srinivasan Keshav Srinivasan
    31. July 2013 at 19:42

    Scott, the thing is, the same public that thinks the CPI understates true inflation, also thinks that the inflation target should be 0%. They don’t want their cost of living to go up at all, and they don’t want the dollar to lose value at all.

  27. Gravatar of George Selgin George Selgin
    31. July 2013 at 19:49

    Hmmm. Sounds to me like another argument for a productivity norm :)

  28. Gravatar of TallDave TallDave
    31. July 2013 at 19:57

    Hedonics has some unexpected outcomes, like people valuing cell phones more than running water. I’m not sure inflation can really be meaningfully boiled down to one number that applies across an entire economy.

  29. Gravatar of Waffles Waffles
    31. July 2013 at 20:19

    Your China analysis is very sloppy.

    http://www.project-syndicate.org/commentary/the-limited-room-for-chinese-stimulus-by-yu-yongding

  30. Gravatar of Benjamin Cole Benjamin Cole
    31. July 2013 at 20:44

    “Inflation is higher than the government says” may also have something to do with real estate prices in NYC and LA, the two media centers.

    It is true—natives of those two cities usually cannot afford the lifestyles of their parents (conceding that even so it is not an apples to apples comparison, what with improvements in health care, technology etc).

    Toss in higher Social Security and Medicare taxes, and the perceived need to send kids to private schools when public used to do…and you see real declines in living standards in Los Angeles in the last 40 years for “average” people.

    But there has also been an explosion at the top: Someone is buying those houses for $4.4 million and driving automobiles worth more than a Harvard education. Fancy restaurants, absent 40 years ago, are stuffed.

    I would guess someone raised in Manhattan in the 1960s would have the same feeling….

  31. Gravatar of mbka mbka
    1. August 2013 at 01:21

    Scott,

    the little anecdotal evidence I have on inflation perception in Europe is twofold.

    One, people assume by default that prices go up too much, no matter what they’re really doing. The 1920s hyperinflation in Germany and the 70s have cemented this into an unquestioned truism. Data don’t even matter. When Austria joined the Euro, it was “common knowledge” that prices would rise, and many people will tell you that they did (usually based on a single observation of the odd bar that charged ten cents more for a beer just about the time of the conversion). Meanwhile, for me, who visits Austria once a year, prices are amazingly low given the context. I’ve said this before – time and time again I see industrial products (cameras, washing machines) cheaper in some Austrian supermarket (20% VAT) than in Singapore (7% VAT). I attribute this to EU economies of scale, including banking industry economies of scale thanks to the Euro. But I am alone in this thinking.

    Two, in many European countries, but not all, real estate prices have risen sharply in recent years. Austria seems to go through a phase where real estate rises at 10-15% p.a. Anecdotally people will tell you this is because there aren’t enough interesting investment opportunities around, so people plough their extra cash into real estate for fear of inflation if they left it at the bank. (the irony!).

    Automatic increases in nominal income through collective bargaining are seen as a God given right in Europe but rises in price levels are an inflationary outrage or proof of sinister ploys to world domination by oil producers and agro-industrial MNCs. It’s just like that.

  32. Gravatar of ssumner ssumner
    1. August 2013 at 06:15

    Keshav, I agree they like the idea of stable prices, but they certainly wouldn’t expect the Fed to be able to hold prices stable. Of course the Fed could, but the public doesn’t know that.

    Talldave, That’s an understatement.

    Ben, Good point.

    mbka, I think the public sees inflation in the long run in the way I describe, a rise in the cost of living. In the short run I believe they see it in terms of supply shocks, which I think explains you final paragraph.

  33. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. August 2013 at 06:30

    ‘You can fool all of the people some of the time, and some of the people all of the time…and those are pretty good odds.’–Bret Maverick’s Ol’ Pappy

  34. Gravatar of Floccina Floccina
    1. August 2013 at 08:35

    The public thinking on inflation is wacky. If any price rises they call it inflation. On guy said to me “Food and fuel prices are rising what else do regular people buy?”. Of course they spend much more money on other things than on Food and fuel!

    And about the complaints about gasoline prices people seldom consider that the efficiency of ICE’s has been rising at about 1% per year for the last 30 years cars have also been getting safer so that smaller car are now safer than bigger cars were and so getting around at a given level of comfort and safety uses less gasoline.

  35. Gravatar of Keshav Srinivasan Keshav Srinivasan
    1. August 2013 at 09:53

    Scott, I think the public definitely knows that the Fed could keep prices stable if it wanted to. What makes you think otherwise? Why else does the public keep complaining about the Fed printing money and debasing the dollar?

  36. Gravatar of ssumner ssumner
    1. August 2013 at 09:58

    Keshav, Most people think of inflation as a sort of natural process. Prices just naturally rise over time. If you did a poll, I’d guess that less than 10% would think the Fed could produce zero inflation. Most don’t even know what the Fed is. And those that do grossly underestimate the power of monetary policy.

  37. Gravatar of Benny Lava Benny Lava
    1. August 2013 at 15:24

    I mostly agree though I still think that the public confuses inflation with purchasing power. When wages rise faster than inflation no one complains. But in 2009 when prices were deflating, wages were also sinking and there was a big complaint about inflation. I think therein lies the problem.

    Yglesias once opined that people are consuming more now than ever so there isn’t really a big problem but I see falling birth rates as a decline in the most expensive consumption of all. Possibly most important too.

  38. Gravatar of Jim C Jim C
    1. August 2013 at 19:22

    The insight here is important, except for the conclusion. Income distribution changes, and what matters to people is their income relative to their ‘reference group’s – one of the few ideas from sociology that economists should pay more attention to. So if people compare themselves to what they see on the TV (i.e. the lifestyle affordable if you are in the top 5% of the income distribution), you’ve got an insoluble problem in the US and UK if the income distribution continues to skew toward exactly that group …. The ‘population’ will always think inflation is faster than it actually is …. Another reason to worry about income distribution trends ….

  39. Gravatar of Secondary Sources: Recession Indicator, Fed and Inflation, 8th Fed Governor – Real Time Economics – WSJ Secondary Sources: Recession Indicator, Fed and Inflation, 8th Fed Governor - Real Time Economics - WSJ
    4. August 2013 at 16:42

    [...] –Fed and Inflation: Scott Sumner says the Fed should target the public’s idea of inflation. “Let’s say the public does think of the cost of living in terms of the amount of money needed for an average lifestyle. In that case, what variable should the Fed stabilize? Obviously growth in average incomes. And if population growth is fairly steady at 1% per year, then one way of stabilizing average per capita income growth at 4% per year, would be to set a 5% NGDP target. So the public actually favors NGDP targeting, they just don’t know it. BTW, if my theory were correct then the Chinese people should believe that the cost of living in China is rising really, really fast, even though the inflation data shows a very slow rise in prices. That’s because nominal incomes are rising very fast in China. And they do!” [...]

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